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Many investors who are fans of mortgage REITs are pointing to the possibility of a near-perfect scenario: The Federal Reserve stops buying mortgage-backed securities (which would mean higher yields on mortgage-backed securities) but keeps short-term rates extremely low.

This would be the sweet spot for mortgage REITs because they would be able to continue to borrow money cheaply, but can then invest in higher yielding mortgage-backed securities. In other words, their spread would increase and thus their profitability.

Even though many mortgage REITs pay a nice dividend, investors are sometimes surprised by the hefty tax bill. REITs are taxed at ordinary income tax rates if they are in taxable accounts, which takes a big bite out of the total return for many. But there is a way to get around this tax bill if an investor has capital losses he can use. I call this strategy dividends to capital gains conversion.

The idea is this: By taking dividends in the form of capital gains, and then offsetting those gains with capital losses you may have, you can pay an effective tax rate of 0%. Compare this to paying either the 15% rate for qualified dividends (for most people) or your top marginal income tax rate on REIT investments.

So how does one go about converting dividends to capital gains? It takes some monitoring, but it could very well be worth your time. First let's define the ex-dividend date for a stock:

The ex-dividend date is the day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. This is an important date for any company that has many stockholders, including those who trade on exchanges, as it makes reconciliation of who is to be paid the dividend easier. It is just as important for investors, however, since you must own a stock before the ex-dividend date in order to receive the next scheduled dividend.

Source: here

If an investor buys the stock on the ex-dividend date or after, he is not entitled to the next dividend. This also means that if an investor sells the day before the ex-dividend date, he is not entitled to the next dividend.

Given this, an investor can buy a stock the day of the ex-dividend date and sell the day before the next ex-dividend date, and be assured that he will never receive a dividend. Some might be saying what a horrible deal! But Mr. Market is no dummy. Those who buy on the ex-dividend date and sell the day before the next one will benefit from the stock price climbing by the amount of the dividend during this time. If you ever notice why a stock's price drops the of the ex-dividend date, this is because those buying it on that day will not receive the next dividend. In fact, the price drops by the amount of the next dividend. Conversely, the stock price will begin climbing the day after the ex-dividend date and will eventually rise by the amount of the dividend. Of course, the price will fluctuate due to other variables, but the amount of the next dividend is always embedded in the price.

Hopefully this all makes sense because for stocks with high dividend yields, as this strategy could provide a huge gain for investors. Let's take a look at how this strategy might be used with Annaly Capital (NLY), which has a dividend yield today of 11.5%.

Every quarter if I buy NLY on the ex-dividend date and then sell it the day before the next ex-dividend date I pay no taxes whatsoever on this dividend, yet receive all of the dividend yield in the form of capital gains. I avoid taxes by offsetting the gains with capital losses. This is a huge benefit to me because NLY is a REIT and investors must pay the full income tax rate on any dividends that are paid.

Let's look at an example using NLY where an investor buys 5,000 shares. The combined marginal federal and state tax rate for the investor is 33%. The investor is able to offset all capital gains with capital losses and pays $8 per trade. I ran the following using our publicly available calculator called Minimize Taxes by Trading Dividends for Capital Gains and readers are free to run their own scenarios as well.

(click to enlarge)

I will have accumulated nearly $63,000 more over 10 years using this strategy. That is a cumulative return that is 80% higher than if I just collected the dividend. I can also adjust the amount of the capital gains that I can offset. Let's say I can offset 50% of the gains with capital losses. It is still worth it because this strategy delivers a 49% higher return than not using the capital gains conversion strategy.

Other REITs where this strategy would work well are American Capital Agency Corp. (AGNC), New York Mortgage Trust (NYMT), Dynex Capital (DX), Anworth Mortgage Asset Corp (ANH), and Hatteras Financial (HTS).

Ticker

Dividend Yield

AGNC

15.7%

NYMT

15.0%

DX

11.2%

ANH

9.9%

HTS

10.3%

Because of the monitoring involved and the trading costs, this idea is best suited for those stocks with relatively high dividends. In the example above, if the dividend yield were below 2%, this strategy does not pay off any more. But for REITs and other high yielding stocks, especially those where dividends are taxed at your income tax rate, this strategy will be a sure-fire winner.

Source: How To Reduce (Or Eliminate) Taxes On Annaly's Dividends